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With legislative proposals on sustainable finance and regulatory pronouncements that stress testing exercises should take full account of climate change risks, this topic is now firmly in the regulatory mainstream.

Sustainable finance

In May 2018, the European Commission issued a legislative package on sustainable finance, aimed at asset managers, investment funds, investing institutions (including insurance companies and pension funds) and intermediaries. It includes:

  1. Harmonized criteria (a taxonomy) for determining whether an economic activity is "environmentally-sustainable”;
  2. Disclosure requirements for institutional investors and intermediaries;
  3. The creation of new categories of low-carbon benchmarks; and
  4. Amendments to MiFID II (Markets in Financial Instruments Directive II) and IDD (Insurance Distribution Directive) to integrate sustainability preferences into financial advisers' suitability tests.

See KPMG alert: EU strategy on sustainable finance for more details. The regulation on low-carbon benchmarks is already at “trilogue” stage (discussions between the European Parliament, Council and Commission), but the core Taxonomy regulation is progressing much more slowly. It remains to be seen whether the full package will be agreed before the European Parliamentary elections in May, despite the attendant pressures to finalize as many outstanding proposals as possible.

The European Insurance and Occupational Pensions Authority (EIOPA) is consulting until 30 January 2019 on the integration of sustainability risks and factors in Level 2 regulations under IDD and the Solvency II Directive. And the European Securities and Markets Authority (ESMA) is consulting until 19 March 2019 on:

  • Integrating sustainability risks and factors in MiFID II. Firms will need to take into account environmental, social and governance (ESG) preferences in the context of assessing clients' investment objectives and to consider ESG factors in the context of product classification;
  • Requiring UCITS and AIF to incorporate sustainability risks into their internal procedures and investment processes, and to identify and manage conflicts of interest; and
  • Guidelines on minimum disclosure requirements in press releases on credit ratings, including whether and how ESG factors were considered as key underlying elements of the rating.

Meanwhile, the Commission issued on 4 January 2019 draft amendments to the IDD and MiFID II Level 2 Regulations to provide the legal basis for how ESG considerations must be taken in account in advice given by investment firms and insurance intermediaries. The rules will come into play only when the fourth element of the main legislative package has been agreed.

Potential ESG requirements for banks

ESG considerations are extending into other legislative proposals, too. We understand that the trilogue on revisions to the Capital Requirements Regulation (CRR2) may be finalized soon and may lead to:

  1. The European Banking Authority (EBA) to assess the potential inclusion of a credit institution's ESG risks in the Supervisory Review and Evaluation Process (SREP) and possibly to develop guidelines.
  2. A requirement for (larger) credit institutions with listed securities to disclose their ESG risks.
  3. The EBA to investigate options for reflecting ESG considerations in the risk weighting of exposures.

Stress testing by banks and insurers

Meanwhile, there is already increasing pressure for banks and insurers to incorporate the full panoply of climate change risks in their stress testing exercises. EIOPA is to deliver by 30 April 2019 recommendations on how existing regulatory frameworks might incorporate sustainability risks and factors, and an opinion on the impact of Solvency II on insurers' sustainable investment and underwriting activities.

National regulators are also increasingly focused on the issue. The UK's Prudential Regulatory Authority, for example, is consulting on its expectations for regulated firms to draw up credible plans to protect themselves from financial risks associated with climate change. Firms will need to embed climate change within the existing governance framework and assign board-level accountability for oversight. CROs will need to consider long-term scenario testing to inform the firm's strategic response to climate change and build climate change risk into risk management processes.

What it means for firms

It is clear that this topic is now firmly on the regulatory agenda. Until the various new rules are finalized, the impact on regulated firms and their clients cannot be precisely calibrated. It is certain, though, that regulatory and client pressures will be at the forefront throughout 2019 and beyond. Firms will need to incorporate ESG considerations across their business. For further information, please visit the KPMG Global Sustainability Institute.

This article was originally published in Horizons: The outlook for financial services regulation (PDF 1.1 MB) in January 2019.

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